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RBI to tighten stance from here on

ET CONTRIBUTORS|

Updated: Jul 30, 2018, 09.06 PM IST

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RBI likely to do a cumulative tightening of more than 50 bps during the rest of FY19.

With RBI’s rate decisions now being guided by inflation targeting objective, the recent pickup in inflation momentum will see the central bank hike repo rate by another 25 bps on August 1 to 6.50 per cent.

With this, RBI will move past the level last seen in October 2016 when it had adopted a ‘neutral’ stance, implying that the next rate hike will be the first move towards a ‘tightening’ stance in the current cycle.

We now believe that with the sharp rise in both CPI and WPI inflation, RBI may do a cumulative tightening of more than 50 bps during the rest of FY19.

Retail (CPI) inflation continued to harden in Jun’18, rising to 5.0 per cent YoY, along with persistent rise in core inflation at 6.4 per cent. WPI inflation is at a five-year high of 5.8 per cent YoY, picking up way beyond CPI inflation due to a sharper rise in commodity inflation.

Rising input prices and currency depreciation indicate build-up of inflationary pressure down the line. A combination of higher government spending ahead of the upcoming elections, its reflationary impact and re-emergence of margin pressure for the manufacturing sector will increase both WPI and CPI headline inflation going forward. Also, increasing global trade restrictions and tariff hikes can impart further inflationary pressure.

We expect food inflation to rise in FY19 on the back of significant hike in MSP kharif prices (15 per cent), higher government procurement and supply shortfall (due to lower kharif sowing area this year).

Monsoon has been normal this year (-3.5 per cent below long period average as on July 2018). Overall sowing during the ongoing kharif season at 63.1 million hectares is 4 per cent lower than normal and -9.3 per cent YoY.

Farmers appear to have responded by lower sowing in crops that have seen weak realisations in the past, viz rice (-12.4 per cent YoY), pulses (-18 per cent YoY), coarse cereals (-10.6 per cent YoY), oil seeds (below normal for the past two years). Sugarcane is the only crop where sowing is higher.

Liquidity tightness to intensify; RBI to resort to higher OMOsLiquidity position, as per LAF, has been increasingly tightening in July. All the parameters till July 2018, such as currency in circulation at 26.4 per cent YoY growth and reserve money growth at 22.1 per cent, are moving in line with our estimates.

However, contrary to our expectation of FCA accretion of 5 per cent in FY19, so far it has declined by US$19.4 billion from March 2018 end. These conditions indicate tight liquidity going forward and it needs to be supported by higher durable liquidity injection by RBI.

Our assessment of cyclical recovery in credit demand (15-16 per cent), normalisation of currency demand to pre-demonetisation trend and tapering of incremental foreign currency assets (FCA) are expected to push demand for reserve money to 24% in FY19E.

The tightening global liquidity may lead to lower contribution of FCA to base money expansion, thereby increasing the burden on RBI to induce liquidity by way of monetizing G-Secs through OMO purchases and other money market instruments. Our estimate of OMO purchases of Rs 2 trillion in FY19E was based on the assumption of a modest 5 per cent rise in FCA; given the decline thus far, the risk is now on the higher side.

RBI has purchased Rs 200 billion through OMO till date, even as it’s incremental lending to the government, including OMOs, stands at Rs 1.86 trillion. This is nearly 7.5 times the amount it lent during the same period last year. In our view, RBI is likely to get more aggressive on this front and might also announce a slew of liquidity measures.

Overall, we expect the G-sec curve to undergo bear flattening with 10-year fair value estimated at 8.4 per cent (currently little less than 8 per cent), along with the short-end aligning with repo rate hikes.

Rising credit demand reinforces our view of cyclical upturn, which will be dominated by well capitalised private lenders, including corporate banks that have geared themselves towards enhancing their retail franchise.

(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)